By long-term, I mean that we work to significantly increase clients’ net worth over a period of years, decades or even generations, not months, weeks or fiscal quarters. Patient compounding of equity is our game. History shows that no asset class has done a better job for its owners than common stocks over the long haul. (Stocks have done plenty of damage for short periods of time!) Archimedes, the ancient Greek credited with the invention of devices such as the pulley, the water screw, and sundry ingenious war machines, supposedly said that if you gave him a long enough lever, he could lift the whole world. Time is the Archimedes lever of investing.
We are fundamental investors in that we begin with the following premise: When you buy a common stock, you become part owner (maybe a very small part owner) of a business; and that over the long haul as the business thrives (or fails to thrive), so shall your investment thrive (or fail to thrive). Again, all kinds of crazy things can and probably will happen to the value of your investment for short periods of time, but ultimately economic fundamentals drive value.
If you buy our premise, the question then becomes, well, what kind of business would you like to own? There are six characteristics I would like to see in any business I own.
I would like to own a profitable business, as profitable as possible. After all, I can make a percentage point or two holding U.S. Treasury notes without incurring the risk of business ownership. I would hope to earn many times more than the risk-free rate of return in any enterprise in which I hazard hard-earned capital. Furthermore, I would like to own a business that is consistently profitable, a business that makes good money in bad times as well as in good times.
While profitability may seem a blindingly obvious requirement for long-term investment, keep in mind that there are periods when companies with neither profits nor the prospect of profits become the rage on Wall Street. The dot-com/high-tech craze of the last decade comes to mind. We at Weybosset Research & Management LLC eschew speculative manias.
In addition to a profitable business, I would like to own a business in which profits march progressively higher–in other words, a growing business. Again, consistent growth is the goal, whether the economic sun shines or cold economic winds blow.
Barriers to entry.
Since we live in an approximation of a free market economy, any consistently profitable, consistently growing business is bound to attract competition, which in turn is bound to threaten both profitability and growth in existing firms in any given industry. Therefore I want to own a consistently profitable and growing business evincing some barrier to entry, some reason that competitors cannot come in and spoil the party.
Examples of barriers to entry include: patent protection (pharmaceutical companies enjoy twenty year patents on new drugs); a brand name (Harley-Davidson, for instance, does not necessarily make the best motorcycle on the road, and certainly not the least expensive, but Harley customers would not dream of riding any other bike); and sometimes a company is the low-cost producer in its industry to such an extent that would-be competitors face insurmountable difficulties.
Exceptional management with significant equity ownership.
Some people have a talent for playing the piano; some have a talent for throwing footballs; and some have a talent for making money. I want the latter running my business. (I prefer to listen to the first type and cheer for the second type.) Appraising management competence includes checking the reputation of the company’s sales organization, research and development expertise, financial skill, etc. But the most important thing in evaluating a company with a record of profitability, growth, and success at keeping competitors at bay is to make sure that the management that produced an enviable record is still in charge. If this is the case, it is likely that the company will continue to produce superior returns, barring, of course, some sea change in the business.
We particularly favor a successful business run by the founder. Many benefits accrue to the shareholders of a company of this type. First of all, I may have 5% of my portfolio and my clients may have 5% of their portfolios in the stock, but the founder probably has 100% of his or her net worth, and close to that much of his family’s net worth, tied up in it. Nobody cares more about the long-term value of the stock than the founder/owner/manager. Management’s economic interests and shareholders’ interests are thus identical.
Secondly, if you have a consistently profitable, consistently growing company that is protected from competition still run by the person who invented the business, confidence increases that the glorious past will segue into an equally glorious future to the benefit of all shareholders.
Finally, no one is more likely than the founder/long-time manager of a company to know when the business has maximized its value and that the time has come to sell. We have seen numerous instances in the last 30 years when a founder/manager sold at a handsome premium to a larger company just as the business began to peak and roll over. Minority shareholders, including us, were more than grateful.
Clean, cash-rich balance sheets.
I am a debtophobe. I want companies with little or no debt. By definition, a company that does not owe money cannot go bankrupt. Lack of onerous debt payments can well mean the difference between survival and extinction when times get rough.
One subset of the cash-rich balance sheet theme has to do with the cash-generating ability of a business. I want a company that, in the normal course of operations, brings in more cash than it needs to spend to keep the business running. For instance, if an automobile company wants to sell more cars, it first must buy more steel, more rubber, more glass, etc.; then it can build and (hopefully) sell more cars. But a software company can sell the same piece of merchandise over and over. From a cash generation point of view, software is a much better business than automobile manufacturing. (Software faces its own challenges, however, when it comes to barriers to entry.)
Cash generation is crucial in another sense, too. If I own a consistently growing, consistently profitable business, I want my company to be able to finance its growth with internally generated funds and not depend on the good graces of banks or Wall Street, notoriously fickle sponsors.
Another advantage of a business that generates lots of cash is that management faces a number of options, most of them happy, with regard to the deployment of surplus cash. Ideally, money can be reinvested in the business for yet more growth, and the shareholder owns a “compounding machine”, the best of all investment possibilities. If growth opportunities are not at hand, cash can be used to increase dividends or buy back stock, increasing each stockholder’s proportional ownership of the company. More risky but sometimes fruitful, acquisitions can be made. Management must allocate capital RATIONALLY and in the interest of all shareholders, and NOT in such a way as to gratify imperialistic aspirations of top executives.
Lastly, I would like to purchase a business with all the above attributes at a reasonable, or better yet, a cheap price. It is said that in real estate only three things matter: location, location and location. In the world of investing, the only three things that matter are price, price and price. (One of the glaringly obvious truths routinely ignored by investors is that the price paid for a security determines the return it will generate.)
A reasonable price paid for a stock is the best defense against the inevitable mistake—not every investment will work out well, after all—turning into a real disaster. A low price means that the market does not expect much from this company anyway; if already low expectations are fulfilled, there is not likely to be much disappointment in the marketplace.
But a low price paid for a great company, one that is consistently profitable, grows consistently, is protected from competition, enjoys exceptional leadership and is conservatively financed, is also the best offensive weapon in investing. Great companies do not ordinarily sell at cheap prices; they command premiums. If a great company is selling at a low price, it must be because, for some reason, the market misappraises the business. Maybe the company has hit a temporary rough spot but soon will return to good times. Maybe stocks in general, whether a particular segment of the market or the entire stock market, are depressed and excellent companies have been sold off along with ordinary and poor companies. Whatever the reason, if a great company is bought at a low price and then the market reappraises the stock, i.e., accords it a higher valuation on rising earnings, really big profits lie ahead for shareholders. The results can be almost magical.
If we can find a company that meets the above criteria, we buy it and hold it, ideally forever, for long-term appreciation and income. No attempt is made to trade or “play” the stock market. We do not care whether a company writes insurance or writes software, whether it manufactures motorcycles or fuses, whether it sells high-end clothing or wrecked automobiles; if it fits our criteria, we are interested.
Another characteristic that does not affect our investment decisions is market capitalization, a company’s shares outstanding times the price per share. We own some huge companies, some very small ones, and many medium-size companies. Big companies enjoy certain advantages, but so do little companies. We are looking for a sustainable competitive advantage, no matter what that might be.
The preference for businesses with long histories of growth and profitability tends to lead us to larger, blue chip names, while the bias for successful businesses still run by the founder tends to lead to small-and medium-size companies.
Finally, it should be noted that the types of companies we favor selling at prices we are willing to pay are few and rare. Thus our portfolios typically hold no more than 20 or 25 stocks at a time.